What Is Option Trading?

by Amanda Harvey

‘What is option trading?’ is a frequently asked question by people wishing to participate in the world of the stock markets. Option trading is often perceived as complicated and risky. Buying and selling shares is better understood as a general concept than buying and selling stock options, however option trading is a form of trading which offers many benefits.

In answer to the question, ‘what is option trading?’, it simply involves buying a contract which gives the trader the right, but not the obligation, to purchase an amount of the shares on which the option is based during a set period of time, at the end of which, the option expires.

Video Introduction to
"What Is Option Trading?"

What is Option Trading Compared to Stock Trading?

Stock trading entails actually buying a part ownership of the company from which the shares are offered. Buying shares requires a substantially larger investment of capital than buying their corresponding options. Assuming that the stock price rises, the stock trader is then able to sell the shares at the increased prices, thereby realizing a profit. If the price fails to rise as expected, they must either hold onto the shares, hoping for the increase to occur at a later stage, thereby tying up the capital invested, or sell at a loss to release the remaining funds.

The option trader, instead, purchases a contract entitling them to purchase the underlying stock within the duration of the contract. The price of an option contract (its premium) is calculated according to many factors including the length of time to expiry, and the volatility of the underlying stock. The premium is a fraction of the price of the stock, meaning that the trader can control an amount of stock for a fraction of the cost of actually purchasing the shares.

What is Option Trading Strategy for Profit?

During the life of the option contract, if the stock price rises, the trader has two basic choices of how to take advantage of this increase.

They may decide to sell the option at a higher premium before expiration, immediately realizing a profit. This is a strategy employed by traders who could be classed as ‘true option traders.’ Rather than getting involved in buying and selling stocks, they simply trade options.

The other method of profiting through the use of options, is to wait until expiration of the contract, and then to purchase the underlying stock at the contracted price which is at that point below market value. The trader can then sell the stocks at the higher price, achieving a profit. The consideration with this approach is that a much larger amount of capital must be outlaid to purchase the stocks – even if only for a short time. The other alternative is buying the shares and holding them for a longer period in anticipation of further increase.

What is Option Trading Risk?

When considering the question of what is option trading risk, there are a couple of aspects to take note of.

With the option contract itself, the risk is basically limited to losing the amount of the premium paid. If a contract expires and the stock price has dropped below the contract price, the option becomes worthless. The trader could sell the option prior to expiration, even at a much lower price than what they paid, in order to salvage a part of their investment. One way to avoid losing more than a certain percentage of the premium is to set a stop loss when purchasing the contract. This would ensure that if a price drops below a set percentage, the option will be sold, securing the remaining portion of the initial investment.

The other type of risk to be aware of is the risk of becoming obligated to actually purchase the shares if the option expires ‘in the money.’ If a trader does not wish to buy the underlying shares, and the price has risen above the contract price, then they must sell the option prior to expiration unless arrangements have previously been made with their broker to the contrary. If it expires (without arrangements having been made), then they must buy the shares, which may be a good strategy providing that this is what they wish to do, and they have sufficient capital available to make the purchase.

In Conclusion

In conclusion to this article addressing the question of what is option trading, this form of trading is a viable way to participate in the momentum of the stock market for a lower outlay and with a correspondingly minimized risk than trading shares.